A derivative contract is a contract between two parties that specifies conditions (e.g., dates, resulting values of underlying variables, and amounts) for which payments are to be made between the parties. Some of the common variants of derivative contracts include a forward, which is a non-standardized contract between two parties where payment takes place at a specific time in the future at a current predetermined price; a future, which is a standardized contract to buy or sell an asset on or before a future date at a price specified today; an option, which is contract giving the owner the right, but not the obligation, to buy (in the case of a call option) or sell (in the case of a put option) an asset at a “strike” price at a time specified by the option contract; a warrant, which is a long-dated option and generally traded over-the-counter; and a swap, which is a contract to exchange cash (flows) on or before a specified future date based on the underlying value of currency exchange rates, bonds/interest rates, commodities, stocks or other assets.
Clearing relates to the activities from the time a commitment is made for a contract transaction until it is settled. That clearing time period (the cycle time for completing the transaction) is much longer that the time it takes for the transaction commitment to occur, e.g., a buy-sell match. Clearing itself involves the management of post-trading and pre-settlement credit exposure to ensure that trades are settled in accordance with market rules even if a buyer or seller might become insolvent prior to settlement. Clearing processes include reporting/monitoring, risk margining, netting of trades to single positions, tax handling, and/or default handling.
Settlement is a process where securities or interests in securities are delivered, usually against (in simultaneous exchange for) payment of money, to fulfill contractual obligations arising under financial instrument trades. For example, the settlement date for marketable stocks might be 3 business days after the trade is executed, and for listed options and government securities, it might be 1 day after the execution. As part of performance on the delivery obligations entailed by the trade, settlement involves the delivery of securities and the corresponding payment.
Multiple risks arise for the parties during the settlement time, which are managed by the clearing process. Clearing also typically involves modifying the contractual obligations associated with the trade so as to facilitate settlement. A clearing house is a financial entity that provides clearing and settlement services for financial and commodities derivatives and securities transactions. A clearing house intercedes between two clearing entities (also known as clearing members) in order to reduce the risk that one (or more) clearing participants fails to honor its trade settlement obligations. A clearing house reduces the settlement risks by (1) netting (netting means to allow a positive value and a negative value to set-off and partially or entirely cancel each other out) offsetting transactions between multiple counterparties, (2) requiring collateral or margin deposits, (3) providing independent valuation of trades and collateral, (4) monitoring the credit worthiness of clearing participants, and in many cases, (5) providing a guarantee fund that can be used to cover losses that exceed a defaulting clearing participant's collateral on deposit.
Once a trade is executed by two counterparties, the trade is provided to a clearing house which then “steps” in between the two original traders' clearing firms and assumes the legal counterparty risk for the trade. In derivatives trading markets, the clearing house interposes between buyers and sellers as a legal counterparty, i.e., the clearing house becomes the buyer to every seller and the seller to every buyer. This process of transferring the trade title to the clearing house is typically called “novation.” As a result, there is no need to determine the credit-worthiness of each counterparty, and the only credit risk that the participants face is the risk of the clearing house committing a default. Thus, a clearing house assumes the risk of settlement failures and also isolates the effects of a failure of a market participant.
In a derivative market place, in exchange for taking on the counterparty risk, the clearing house requires derivative contract trading participants to provide a certain amount of collateral for each contract. The amount of collateral the trading participants need to provide is often calculated as a margin. As some derivative contracts are mutually exclusive, some contract obligations can be netted when calculating the margin, which means that the trading participant may provide less collateral than if providing collateral for each contract individually.
But a trading participant that wants to trade the same derivative contract on multiple markets, e.g., different trading exchanges, does not enjoy this netting benefit (and thus lower margin requirement) because the clearing houses for the different markets each requires collateral for only one part of the contract rather that both sides of the contract as is the case when a trade is handled at the same marketplace by a single clearing house. This issue arises for example when trade order-routing is used to ensure that trading participants receive the best price across several market places. In this situation, a trading participant cannot be sure at which marketplace an order will ultimately be traded. Another disadvantage in this best price order routing situation is that the trading participant must be a member or associated with a member of multiple clearing houses.